The Definitive Incomplete Analysis Of Today's German Shock And Awe

As BaFin has yet to provide details of the naked short ban, here is the best "incomplete" analysis of today's events, written by BofA's Jeffrey Rosenberg.

Cleaning up the spill without stopping the leak

Today’s actions by the German Financial Regulator BaFin prohibiting naked short selling continues a long simmering approach to the European sovereign debt crisis that we believe mistakes financial market uncertainty for the cause of the crisis rather than its effect. Drawing an analogy to the other major headlines of the day, attempts to curtail the sovereign debt crisis through curtailing trading activity is like trying to clean up the Gulf oil spill without stopping the leak. Budget deficits are the leak in this analogy and are similarly extremely difficult to fix. By confusing the cause for the effect the policy response exacerbated rather thanameliorated market uncertainty and with concern over the loss of ability to hedge long positions, investors sold what they could with the declines in the Euro leading risk markets lower and US Treasuries higher in a flight to quality.

Creating confusion: the BaFin ban

Today, the BaFin announced a series of short-selling bans aimed at reducing financial system risk. The bans will begin at midnight tonight (18th-May) and last until 31 March 2011 (10.5 months). The ban will apply to naked short-selling of credit default swaps and Euro-area government bonds. In addition, the ban will apply to naked short-selling in shares of 10 German banks and insurers. The 10 names are: Allianz, Deutsche Bank, Commerzbank, Deutsche Boerse, Deutsche Postbank, Munich Re, Hannover Re, Generali Deutschland Holding, MLP and Aareal Bank.

So what does that mean?

We have more questions than answers at this point. First, naked short selling is well defined for cash markets – stocks and government bonds. It bans the selling of those when the seller can not deliver the asset to the buyer (within a proscribed period of time). These bans were put permanently in place for example in the US during the credit crisis. For CDS, “naked short-selling” is not well defined. There is no delivery of an underlying instrument in a short risk position in CDS (buyingprotection), hence some other definition of what “naked” means for CDS will be required. How “naked” is defined could render market making difficult or impossible. Enforcement is unclear as well as the jurisdiction of trading to which the BaFin ban applies. That latter point could become moot were FSA and othernational regulators to follow suit with similar bans. Finally the scope of what “Euro area” debt means remains undefined.

And what does it mean for SovX?

Again, at this point we don’t know. Presumably as SovX underlying all reference Euro area government debt, whatever definition of “naked short” applies to CDS would also be applied to the SovX index. Should SovX gap tighter or wider? While the knee-jerk reaction to banning short selling may be to collapse short risk positions (leading to a gap tighter in spreads), the second thought is that having just banned naked short selling in CDS, the value of holding an instrument that provides short exposure to sovereign debt may increase. In the experience of the outright ban on shorting financials in the US for example, SEF (a short financial sector ETF) initially declined significantly, but ended up increasing in price far exceeding its levels before the ban was enacted.

Raising the risk of future restructuring

While today’s sovereign markets ended in Europe stronger on the heels of Greece securing EUR 14.5bn loan tranche (and before the ban headlines roiled the markets), the longer run performance of SovX and more broadly the pricing of periphery sovereign debt depends on the fundamental risk of restructuring and whether today’s actions to ban naked short selling appear to increase or decrease that risk. European policy makers’ strategy to stem the crisis is to buy Greece (and other periphery countries) time to implement fiscal tightening. Greece today delivered on the first round of that tightening, and the market response was positive. That illustrates the positive outcome of the intervention. However, markets remain skeptical as one quarter of austerity does not make a Spring – i.e. continued successful efforts will likely be required, and those will become harder over time as the economy contracts as a result of the implementation.

Because the cure can kill the patient

The market’s immediate response to the ban announcement was to sell the Euro. Such a response makes sense as when faced with the inability to manage risk in debt, stock or CDS markets, participants sell what they can. And that means the Euro. But by having inadvertently further undermined the Euro, today’s actions increase the risk of failure in the entirety of the liquidity support program as the Achilles heal of the European intervention is its potential to undermine the currency. Unlike the US policy response, massive liquidity support from the ECB can create the perception (if not the reality) of a debt monetization scheme. While the US explicitly monetized the debt, it benefited from a flight to quality and worlds reserve currency status, neither of which the Euro enjoys. A precipitous decline in the Euro remains the risk to the outlook, and on display today as the Euro declines led the selloff in broad risk markets.

Bringing back bad memories

Non-credit market investors learned the importance of the Libor – OIS spread during the US financial crisis. This of course is simply a modern version of the TED spread – a spread that measures the relative cost of private bank funding costs vs. government funding costs. These spreads continued to trade wider highlighting that the risk of a spread of Sovereign risk into the financials remains high. This occurs despite the decline from peaks in Sovereign CDS and government bond yields. Importantly however, since those markets now face the prospect of banning of naked short selling (CDS) and potentially an unlimited, price insensitive buyer (the ECB’s Securities Markets Programme for sovereign debt), those price signals likely no longer reflect market sentiment. Even in these short term funding markets, the reopening of the Fed’s dollar swap lines with the ECB limits to some extent the sentiment indication. However as the penalty rate for accessing dollar funding through the ECB (at 1%) still stands above the effective cost of borrowing dollars in the private market, the rise in Libor – OIS highlights continued fears of restructuring risk.

I fought the law...and the law of unintended consequences won

Count Bank of Italy’s decision to allow banks holding European government bonds in AFS portfolios to suspend mark to market accounting rules as the latest iteration of unintended consequences. By suspending the rules, inadvertently market uncertainty increases as confidence over the value of the holdings, exposures and hence capitalization erodes. That lack of confidence feeds directly into increasing short term funding costs that the widening in Libor – OIS highlights.